What to Know Before You Leave Your IRA or 401(k) to the Kids
Their tax bill is accelerated under new law
Beginning in 2020, when you leave money in a retirement account to someone other than a spouse, the beneficiary will have just 10 years to empty the account. That is a big change from the old tax law that allowed people who inherited retirement accounts to “stretch” their withdrawals out over their entire life, as long as they made annual required minimum distributions (RMD) based on an IRS formula tied to a person’s life expectancy.
The new law does not change the rules for how spousal inheritances are handled. Spouses still have a variety of stretch options.
For example, before 2020, the first RMD for a 40-year-old, non-spouse (child, grandchild, sibling, the nice neighbor next door) who inherited $100,000 would have been $2,294. The formula would increase the withdrawal rate slightly each subsequent year, but RMDs could continue for the rest of the beneficiary’s life. To be clear, anyone who inherits a retirement account can empty it all into one big withdrawal, but the law only required small annual withdrawals to keep the IRS happy.
Under the new rule, a $100,000 IRA or 401(k) inherited by someone other than a spouse must be drained within 10 years after the year the owner dies. No stretching allowed.
If the money is in a traditional retirement account, every dollar withdrawn is counted as taxable income in the year of the withdrawal.
Exceptions include disabled or chronically ill beneficiaries, those within 10 years of the age of the deceased and minor children of the deceased but only until they hit 18.
10-year rule, but no RMDs
While the new law imposes a 10-year withdrawal timeframe, there aren’t any annual RMDs. All that matters is that by the end of the 10-year window, the account is empty. Fail to do that, and the IRS will assess a penalty equal to 50% of what remains.
Inherited IRAs can mess with financial aid…
A consequence of compressing the withdrawal into a 10-year window is that grown kids may need to take big distributions right around the time their kids are applying to college. Money inside a retirement account doesn’t get factored into financial aid formulas. But distributions from retirement accounts do.
…and even Medicare premiums and Social Security taxation
A study by wealth management firm United Income says that, in 2016, one in four recipients were older than 61 when they received their inheritance. That includes spouses who don’t have to worry about the 10-year rule. But with plenty of folks now living into their late 80s and 90s, it’s reasonable to assume plenty of children will be in their late 50s or early 60s when they receive an inheritance.
If the intention is to start Medicare at age 65, the premium for Medicare Part B will be based on one’s income reported when they were 63.
If a big withdrawal is made from an inherited traditional IRA or 401(k) at 63, that could mean owing a higher monthly premium for Medicare Part B at 65. (The premium is recalculated every year based on a two-year lookback at your reported income.)
And the tax treatment of Social Security benefits is also dependent on reported taxable income. Here too, a distribution from an inherited retirement account could impact the taxation of Social Security benefits.
The conversion option
If you expect to leave behind a sizable amount in retirement accounts, you might consider a Roth conversion, which involves moving money from a traditional IRA to a Roth IRA, or a traditional 401(k) to a traditional IRA at a brokerage and then move that into a Roth IRA.
You will owe tax on the amount converted, so if you’re still in a high tax bracket, this might not be advisable. As just explained, you need to factor in the potential cost to your Medicare Part B premium, and potentially your Social Security benefit if you’re already collecting.
The payoff is that once the money is in the Roth IRA, your heirs would still be subject to the 10-year rule for emptying the account, but they won’t owe tax on the amount you converted. And as long as the Roth account is five years old — from the point you opened the Roth account — they can take out earnings tax free, as well.
If you have multiple non-spouse heirs, with very different tax situations, you might consider leaving more of the Roth to heirs who are already in a high income tax bracket, and earmark traditional accounts for heirs with a lower tax rate. Just be sure to think through the net after-tax inheritance for each.
Head spinning? Working with an advisor who has experience dealing with all the moving pieces is key.
Or maybe consider actually spending more of the accounts now. On you. Or on them. Yes, that has tax implications for you (see above re: working with a tax pro), but it’s an effective way to reduce what is left to inherit, while potentially enjoying yourself even more now, or helping the younger generations start saving for retirement. You could even gift money for funding a Roth IRA. Or help with a down-payment fund for a home.